In a recent article, “The Hoover-Roosevelt Depression Revisited,” work by Cole and Ohanian was highlighted because it comes to conclusions similar to, and thus reinforces historical work previously done by Austrians or fellow travelers (especially Murray Rothbard, Robert Higgs, and Richard Vedder and Lowell Gallaway), which explained the length of the Hoover-Roosevelt Depression.
Why is this work important to Austrians? The work, appearing in journals that even top mainstream economists cannot ignore, adds more evidence that the Austrians were right about the cause of the length of Great Depression, as well as the depth of unemployment and stagnation that was characteristic of the Great Depression. The Austrian explanation of the Hoover-Roosevelt Depression is historically accurate.
Just as in the 1930s, recovery from the Great Recession has been hampered by harmful government interventions, monetary and fiscal actions that impede market liquidation and reallocation of resources, and polices and rhetoric that generate regime uncertainty.1 Explanations which make this case, based on similar Austrian microeconomic foundations should be given strong consideration. Such explanations best reflect actual cause and effect, and thus are better guides to the appropriate policy responses to the crisis and necessary monetary reform needed to prevent renewed occurrences of harmful boom-bust cycles.
The work by Cole and Ohanian is from within the framework developed by two Nobel-winning economists, Finn Kyland and Edward Prescott. The framework is known as real business cycle theory (RBC). The modeling is a subset of equilibrium business cycle models which, in general, have been legitimately criticized by Austrians.2 But some of the results developed by RBC proponents, can supplement the Austrian business cycle theory (ABCT), and add to our understanding of cycle phenomena and other fluctuations in economic activity (see “Capital-Based Macroeconomics: Recent Developments and Extensions of Austrian Business Cycle Theory” or “Capital Based Macroeconomics: Boom and Bust in Japan and the US”)3
RBC theorists see the pattern of expansion and contraction present in economic data as the economy’s response to exogenous productivity shocks. These “modern theories of business cycles attribute cyclical fluctuations to cumulative shocks and disturbances that continually buffet the economy. In other words, without shocks there are no cycles.” Money and central bank policy are largely irrelevant with respect to economic expansions and downturns. Changes in money, as in some of the free banking literature and Post-Keynesian analysis, is assumed to be endogenous. Despite these errors, RBC makes a claim that Austrians should be comfortable with: countercyclical policies are counterproductive and entail costs in excess of benefits.4
Prescott makes the case that the application of the term “business cycle” to describe the observed movements is “unfortunate.” He argues that economists mistakenly attempt to explain cycle phenomena independently from the growth component, and that the phenomena are better understood by the use of a unified theory of growth and fluctuations. Mises, Hayek, and Rothbard took a similar methodical approach — a single unified economic theory. But in Austrian or capital-based macroeconomics, the theory explains not only fluctuations, but also boom-bust phenomena. In Monetary Theory and the Trade Cycle, Hayek (1933, 54-60) differentiates cyclical fluctuations from shocks (fluctuations à la real business cycle models or other exogenous shock approaches). The shock interpretation of economic fluctuations is essentially a “non-economic” — but not necessarily unimportant — explanation of economic change:
The simple fact that economic development does not go on quite uniformly, but periods of relatively rapid change alternate with periods of relative stagnation, does not in itself constitute a problem. It is sufficiently explained by the adjustments of the economic system to irregular changes in the data — changes whose occurrence we always have to assume and which cannot be further explained by economic science.
But the boom-bust cycle presents the theorist with a different challenge: The phenomena of the upward trend of the trade cycle and of the culminating boom constitute a problem only because they inevitably bring about a slump in sales — i.e., a falling-off of economic activity — which is not occasioned by any corresponding change in the original economic data.
Proponents of RBC conclude that their model can account for about 70 percent of the postwar business cycle phenomena [fluctuations]. But critics contend there is “no independent corroborating evidence for the large technology shocks that are assumed to drive business cycles.” A capital-based macroeconomic model helps better interpret historical evidence, even evidence created by other methods, and thus better identify “shocks” while recognizing the harmful effects of monetary and credit creation, which enables one to better separate “shocks” (changes in real economic activity emphasized by RBC and Hayek) from money and credit created cycles as emphasized in ABCT.
Growth rates and the level of productive activity vary and fluctuate in response to shocks, as suggested by the RBC literature. But it should be kept in mind that boom-bust cycles do occur around the shifting growth paths. The boom-bust cycle is always generated by circulation credit. How and when the created credit enters the system can lead to significant historical variations in the boom-bust pattern. But in general, the stylized facts presented by RBC proponents, which show there is greater variability regarding time-related decisions — investment, including variations in inventories, and consumer durable purchases relative to total output and consumption — is consistent with what ABCT predicts as the consequences of credit creation.
At a lower level of aggregation, what looks like an economy’s response to a “positive technology” shock may be in fact an economy’s response to credit creation. The apparent productivity increase is, in reality, a money/credit-induced artificial boom.
Another common and likely scenario is a combined response; the economy is subjected to a truly exogenous productivity shock in new knowledge or improved production techniques. The greater potential productivity of new investment projects of all types increases the demand for credit, but the higher demand for credit is partially accommodated by credit creation.
In either case, the economy-wide response will be a combination of sustainable and unsustainable growth. Part of the expansion of investment during the response period will be malinvestment. As the malinvestments are discovered and corrected, the production structure will shorten, productivity will decline, and the aggregate data will pick up a negative productivity shock. The money and credit creation during the expansion, rather than being a harmless endogenous response of banks to changing market conditions, sets the stage for the boom-bust pattern of the cycle.
While business cycle phenomena may be caused by exogenous shocks or inappropriately tight monetary policy, much of the actual cyclical activity is best interpreted as the consequence of credit-created unsustainable growth. This type of cyclical activity is preventable with an appropriate monetary framework, but may be difficult to correct with short-run macroeconomic policy. A monetary policy based on the principle of sound — not stable — money would accommodate sustainable growth without generating endogenous instabilities and unsustainable growth.
Another reason to highlight the work of Cole and Ohanian, as well as the RBC work in general, is effectively argued by J. Robert Subrick and Andrew T. Young in “Nobelity [sic] and novelty: Finn Kydland and Edward Prescott’s contributions viewed from Vienna” (link gated):
The awarding of the Nobel Prize in Economics in 2004 to Finn Kydland and Edward Prescott represents an opportunity to evaluate their contributions in light of Austrian economics. We lay out the basics of their contributions — the general equilibrium approach to economic fluctuations and the game theoretic approach to policy — and argue that they have tenets similar to those of Austrianism. We argue that their methodology parallels Austrian methodology in several significant ways that have gone unnoticed. We conclude that Kydland and Prescott’s Nobel Prize suggests Austrian approaches can have a more prominent impact than they have had in the past.
Properly understanding historical events is an important, even essential, component of a strategic defense of liberty. Cole’s and Ohanian’s work should be another tool in the arsenal, but much work needs to be done. Vedder’s and Gallaway’s work needs to be extended to include the Great Moderation, the Great Recession, and the current stagnation. Austrians should take up Ohanian’s suggested task for future researchers. Revisit the Hoover-Roosevelt Depression and integrate the impact of all government interventions, including but not limited to cartelization (and crony capitalism), regime uncertainty, and inappropriate fiscal and monetary policies. A similar study of recent events is also warranted. Austrians should take up the challenge of Subrick and Young. Austrians can and should make a more prominent impact especially given the two disastrous boom-busts that occurred post-1998.
- 1See “Capital in Disequilibrium: Understanding the “Great Recession’ and Potential for Recovery.” The Quarterly Journal of Austrian Economics, 13, no. 3, 42-63 or “Are the Austrians Too Harsh?”
- 2See Cochran, John P. and Glahe, Fred R. (1992). "The Use and Abuse of Equilibrium in Business Cycle Theory: A Praxeological Approach" [gated]. Cultural Dynamics 5(3): 356-70 which is also Chapter 11 of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research.
- 3Some of what immediately follows draws heavily on these sources with references omitted.
- 4See The Fraud of Macroeconomic Stabilization Policy another very important paper by Vedder and Gallaway, which appeared in a leading Austrian journal, but has been unfortunately most ignored.
